LONDON, May 8 (Reuters) - Italian government bond yields rose sharply on Tuesday, lifting southern European peers, as the possibility of an early Italian election increased with the country’s largest anti-establishment parties polling strongly.

President Sergio Mattarella called on Monday for Italy’s bickering parties to rally behind a “neutral government”, but Italy’s two largest parties, the far-right League and anti-establishment 5-Star Movement, rapidly came out against the proposal.

This raises the likelihood of an unprecedented immediate return to the polls, even as early as July.

“If we go to a new election, both M5S and the League are polling a bit higher than at the last election, so the worry for markets is that they are able to leave behind Forza and we get the government of non-traditional parties,” said Rabobank strategist Lyn Graham-Taylor.

While the 5-Star Movement and the League already had enough numbers to form a government, a fresh election may further strengthen their hand.

Graham-Taylor said investors are concerned that such a government may repeal pension reforms and potentially increase spending and tax cuts that could impact Italian public finances.

Italy has one of the highest debt-to-GDP ratios in Europe at 132 percent.

The closely watched Italy/Germany 10-year government bond yield spread hit its widest level in more than three weeks at around 132 basis points .

Italy’s 10-year bond yield shot up 10 bps to a six-week high at 1.867 percent and was set for its biggest daily jump since early January.

Milan’s FTSE MIB index fell 1.8 percent, with Italian banks taking a strong hit and set for their worst day in two months.

Carlo Franchini, head of institutional clients at Italy’s Banca Ifigest, said: “Markets were too optimistic about elections and were not expecting there could have been elections so early. That could put at risk the approval of the budget law and recent data has eroded confidence in the country’s economic recovery.”

Other Southern European government bond yields — which move inversely to price — were also higher by 4-5 bps.

Yields in broader euro zone bond markets were also higher as strong German data soothed concerns over the euro zone’s largest economy and increased expectations the ECB will withdraw stimulus as planned.

German industrial output rose more than expected in March, data showed on Tuesday, suggesting that factories in Europe’s largest economy ended the first quarter on a strong footing after two disappointing months.

Separate data published by the Federal Statistics Office showed exports rose 1.7 percent in March while imports fell 0.9 percent.